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We
are halfway through the year, and what a ride it has been. Today I will share
my thoughts on what the next six months could look like, and endeavor to keep
it short and simple, as we have a holiday weekend. There will be more than a
few charts. What does the end of QE2 mean? What can we expect from Europe? Is a
commodity bubble getting ready to burst? Is it really a bubble? There is a lot
to cover.

I
recorded a PBS show a month or so ago, and it is airing this weekend on a number
of stations around the country, so look for details at the end of the letter.
Now let’s jump in.

The
economy should be in Muddle Through range (around 2% growth), absent any
shocks. For instance, today we had the June ISM number, which was stronger than
most analysts expected, at 55.3. There was a lot of whispering that it could
dip below 50. Some of the internal components were a little soft, though. New
Orders were barely above 50. And Backlogs fell below 50. Exports fell to the
lowest level in two years (more on that below). Of the 18 industries surveyed,
only 12 reported growth.

But
Muddle Through is not going to allow us to really cut into the unemployment
problem. We need at least 3% and most economists think we need to see 3.5% to
result in some real strong jobs numbers for several months in a row. That just
doesn’t seem to be in the cards. Richard Yamarone at Bloomberg is calling for a
recession by the end of the year, and he sent me a rather vivid PowerPoint of
his latest thoughts. Let me share a few of those slides with you.

The
following chart shows what I mean by Muddle Through not being enough to really
cut into unemployment. As GDP seems to be slowing rather than picking up, the
correlation between employment and growth is not encouraging. And if you look
at the NFIB (National Federation of Independent Businesses) data, small
businesses are not really back in the hiring game, and that is where the action
needs to happen. We will see a new survey next week, but I doubt we will see a
major jump in expectations.

About
two years ago I wrote a rather lengthy piece about why unemployment would be a
problem until at least the middle of the decade. When you lose 8 million jobs,
with about 2-3 million of those jobs permanently gone, it is tough to dig out
of the hole. We can’t look to housing construction to be the driving force that
it once was for another 3-4 years, and commercial construction is falling.

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I
was talking to a friend yesterday who is a director on two local bank boards.
He pointed out that while the government wants banks to lend, the regulators
(the Fed) are basically saying they can do development loans without very large
equity components. They want 50% loan-to-value of very-reduced valuations.
Let’s look at two charts from Rich. One shows commercial construction and the
other shows regional and strip mall vacancies. Construction spending for May
2011 fell 0.6% below its revised level in April, and is 7.1% below its May 2010
level. This is not the stuff that makes real estate moguls want to part with
their cash. Nor does it bode well for construction jobs.

OK,
only two more charts from Rich (Over My Shoulder subscribers can see the whole
thing. More on that below.) The first is the smoothed ECRI (Economic Cycle
Research Institute) index over the last 20 years. We can see it turning over. The
ECRI weekly leading index decreased to 126.4 for the week ending June 24, from
an unrevised 127. The smoothed, annualized growth rate fell to 2% from an
unrevised 2.9%. The ECRI WLI has been consistently losing momentum in recent
months, adding to concerns about the sustainability of the recovery.

The
ECRI itself points out that their index is simply signaling a weakening economy
but does not signal a recession. And you can see that there have been similar
downturns in the past without a recession or even a recovery. But the recent
trend is disconcerting and must be watched.

And the last chart is one I had
not seen before, and is interesting. Rich notes that if year-over-year GDP
growth dips below 2%, a recession always follows. It is now at 2.3%.

Growth is clearly decelerating.
Look at the growth numbers from the St. Louis Fed website for the last six
quarters:

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It will be very interesting to see, at the end of the
month, what the numbers are for the second quarter. Another quarter like the
first quarter and we should either be close to or actually dip below 2%.

The
problem with a slow-growth economy that is basically at stall speed is, if
there is any type of “exogenous” shock, the economy can easily tip over into
recession. There are several potential sources of a shock coming from the
outside the US.

The first is from
Europe. I have been writing about this for a very long time. It is the number
one thing in my worry closet. We have dodged a short-term bullet with Greece
and Europe coming to terms this week, but in late July they will have to find
AT LEAST €50-70 billion more euros in loans and rollovers, and then more next
year. Without projected asset sales it could reach €100 billion very easily. And
willpower is waning on the part of creditor countries. Opposition against throwing
good money after bad is increasing, as recent polls in Finland, Germany, the
Netherlands, and Slovakia have shown. How long Merkel can hold her coalition
together in the face of growing discontent is not clear. Powerful,
authoritative voices in Germany are starting a daily chorus of chanting “no” to
more bailouts.

And it is not just Greece. After Greece is dealt with, the
Eurozone must deal with Ireland and Portugal. And the market is increasingly
suggesting there is more risk there than the area can handle. Look at the graph
below, which shows the steady rise of interest rates for Ireland and Portugal.
This looks like Greece not so long ago. And Portugal now has higher rates than
Ireland. This means that both countries are effectively cut out of the private
market. (www.ifr.com)

Both
countries keep saying they are not Greece, but the bond markets are not buying
it. And as I noted last week, when Greece defaults, and they will at some
point, the contagion to other countries will be quick and severe. And Spain will
be included. The Italian bank index has been in free fall of late.

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Money
is flying out of Greek banks. Indeed, deposits in all the peripheral countries
are falling. It is quite possible we get a credit or banking crisis in Europe
before we get a sovereign default crisis. The longer Greece waits, the more
they try and kick the can down the road, the worse it gets for their banks. And
Greece has NO money to bail out its banks. Look at this graph from Bridgewater:

And
quoting Bridgewater (one of the more brilliant sources of information in the
world):

“While the focus is for the moment on the
question of bridging Greece’s immediate funding need, it’s important not to
lose sight of the bigger picture, which is that indebtedness is not the
periphery’s only problem, and is in many way only a symptom of the structural
imbalances (extremely negative current account and budget deficit) that plague
it. No amount of funding will change the fact that the periphery continues to
be extremely uncompetitive; that in order to become competitive, it needs to
become much cheaper; and that as long as it continues to be a member of the
euro, the only way to achieve this is through sustained wage cuts and deflation
that would need to be dramatically more extreme than the adjustments they’ve
experienced thus far.”

This could put Europe into a recession. And that is not good for
US exports or for China. China is already in tightening mode. A hard landing is
still too far away to call, but things could get softer, which will definitely
affect commodity prices, which are already rolling over.

And
as of today, the only QE will be that of the Fed taking the drawdown on its
mortgage book and using it to buy Treasuries, which it has been doing. The
markets are going to have to come up with $50 billion in bond purchases, and
the recent auctions have not been all that good. I know the markets liked the
ISM numbers, but a lot of the rise this week was quarter-end gaming by mutual
funds and money managers. Let’s see if there is follow through in July. The
last time QE was stopped the markets swooned. That is only a data point of one,
but it’s all we have.

I think this is a very risky next six months. Maybe we avoid
a crisis somewhere that affects the US and thus the world. If we do, if Europe
can kick the can down the road another six months, then while a slowdown seems
to be in the data, it is not yet suggesting a recession. I would be very
careful about any long-only trades, whether it be stocks or commodities or
bonds. We just don’t know – there is less certainty than at almost any
time I can remember.

“ENDGAME: The End of the Debt Supercycle and How It Changes Everything,” a
program I recorded with McCuistion TV of Dallas, will air on Sunday, July 3, at
12:30 PM on KERA, Channel 13,
Dallas, and also on other PBS stations around the country. You can also view the entire episode next week on
the McCuistion website.

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My
twins, Abigail and Amanda, live in Tulsa; and this year they have demanded that
Dad come to them. It was their birthday last Thursday, so we will celebrate
their 26th. Fireworks on the 3rd after the birthday
dinner! For whatever reason, I do like a great fireworks display. Always have.

It seems like just a few months ago that we went to the
Dallas Airport and saw them for the first time, at six months old. They grew up
so fast. The picture below is from the cover of Twins magazine, sometime in 1987, I think.

Too
cute, yes? And they grew up into such beautiful young ladies, both inside and
out. One was Homecoming Queen and the other Senior Queen. One of the most
touching moments in my life was when one of them won Homecoming Queen and the
other just glowed with love and affection for her sister. Not a hint of
jealously. I caught it in a picture, one of the few times that Dad actually had
the camera in the right place at the right time. And Dad maybe had a moist eye
or two. Dad is proud, and justifiably so.

As
it turns out, my good friend Louis Gave of GaveKal married an Oklahoma girl,
and her family lives about 90 minutes away from Tulsa on a lake somewhere in
Oklahoma, where he visits his in-laws for month every year, with their four
kids in tow. Brave man that he is, he has invited my clan to come over on the 4th
for lake time and BBQ, and there was an enthusiastic “Yes” from the five of my kids
who will be in Tulsa, plus spouses and other friends! So the Mauldin horde will
descend on the Gave tribe and see just how much food they really have stored up
for invasions.

Have
a great 4th of July if you are in the US or celebrating as an expat
in some remote locale. It promises to be a good one for Dad, and getting to
spend time with Louis is a bonus. He is simply one of the smartest financial
minds I know.

Your
betting there are fireworks (hopefully not financial) in
my future analyst,

Options

Discuss This

Comments

Jon Parker

What struck me about the first chart, GDP and Payroll, was the anemic GDP in the last decade. With all of the tax cuts AND deficit spending, why didn’t we see better economic growth?

julius corazo

July 3, 2011, 11:34 a.m.

excellent analysis and very well thought out prognostications, these are dangerous economic times indeed, too many moving parts that have to move in concert and in harmony, otherwise, if we experience any shock in the next 6 months, then there will be more pain and dislocation going forward, for investors, businesses, consumers and governments, which will make the Greece unraveling look like a picnic…hope we avoid these economic pot holes going forward, most people are already too stressed out as it is
p.s. It’s nice to read a business newsletter that has a family bent to it, I like your choice of the name Abigail, my daughter’s name as well…you do have great looking kids…
Happy 4th of July to your family and friends and your American readers! we just celebrated our Canada Day…

julius corazo

July 3, 2011, 11:20 a.m.

excellent analysis, very well thought prognostications, these are dangerous times we are in, too many moving parts that have to behave in concert and harmoniously…if we experience any external shocks, then there will be more dislocation and more pain for everyone, for investors, businesses, consumers, wage earners and governments alike…so here’s hoping we can avoid these scary economic pot holes going forward…
p.s. It’s nice to see an intelligent economic newsletter that has a family bent to it, you have great looking kids, I like your choice of Abigail, I have a daughter with the same name…
Happy 4th of July to your family and friends and all your American readers!...we just had our Canada Day…

Tony Dowell

July 3, 2011, 11:01 a.m.

Jim Rogers has an interesting perspective on Greek problem:
“It’s about Europe bailing out European banks, not Greece”.

Richard Sackler

July 3, 2011, 10:06 a.m.

Your analysis of the Greek situation is to the point. But what wasn’t said was the implications of a default. Greece would likely leave the Euro fairly quickly. With that event, I imagine (I have no knowledge) that some or even most Greek banks would find that many of their Greek assets would be redenominated into a Drachma-like domestic currency (initially a 1:1 conversion) which would rapidly depreciate. But their foreign obligations would remain in Euro. If some of the most important Greek banks collapse (not a foregone conclusion) this might spread to other banks in the Eurozone. Greece might even have to exit the common market if unless most of the private (non-banking) debt can be protected from forfeiture. (I’ve assumed that once Greece exited the common market, they could protect Greek situated assets from seizure from the outside.)
However, shocks aren’t limited to the Eurozone. We have an even more urgent potential crisis brewing in the US with the stalemate on expanding the debt limit. Some commentators are guessing that a market signal—whatever that may be—will be required to get thing unstuck. Whether the market signal would turn into a hiccup or a major ungluing of credit markets world-wide. Strangely, there isn’t much concern expressed by marketplace measures yet, so we would have to see this possibility as remote.

Amir Shaked

July 2, 2011, 8:34 p.m.

And let’s not forget our own, home grown, shocker - the inevitable removal of the fiscal stimulus in the form of a deficit that’s almost 10% GDP; what’s the significance, anyway, of 2.3% vs 2% GDP growth when this grown costs us 10% of GDP?

Valerie Peak

July 2, 2011, 7:08 p.m.

Enjoyed your artice, Tulsa for the 4th, and , having twins myself, can relate. Also, I may never had time to read to the end for some personal info. Thank you for writing and your wisdom! Happy independence Day!

Dave McKay

July 2, 2011, 3:54 p.m.

I think the “Fortress America” trade is the right trade for the near term future. I think long term municipal bonds and coupon clipping is the best idea. With a slowing economy, I don’t think long term rates will rise any appreciable amount, so no big hurt on your continuing bond values. And bolder investors can go with leveraged closed-end municipal bond funds at 7% rates.

Leverage costs are at record lows, and Bernanke won’t be raising short term rates (financing costs for closed-end funds) anytime soon. So, stay at home in your Fortress and do the carry trade, because right now the best carry trade anywhere is right in your home country. Meredith Whitney has been proven wrong and muni bonds are at great prices these days, even after the recent run-up.

andre therien

July 2, 2011, 11:56 a.m.

Great letter ! Succinct and to the point. The world economy and financial system are so vulnerable to any
external shocks, its scary. Time to buy insurance, whether it be Puts, the VIX or Shorts. Europeans are
terrified of defaults and the USA is releasing strategic oil reserves. There is an important message in these acts. Additionally, China is a bubble and Japan is a basket case. Great independence day to all you
Americans.

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